November 2007
Monthly Investment Commentary | November 2007
We regularly use a Q&A format to address questions from readers about our investment views and current strategy. The Q&A format has the advantages of letting us address questions individually without worrying about being limited by a particular theme or subject, and allows readers to focus on areas that are of concern or interest to them. The following was worked on jointly by members of our research team, and addresses questions we received during the past several months. How much subprime exposure do you have within your strategy? Our fixed-income strategies had very little to no exposure to subprime lending. Loomis Sayles Bond had no exposure. PIMCO Total Return did not have any significant exposure and performed well during the credit market volatility, beating the investment-grade bond benchmark by a large margin in the turbulent third quarter. On the equity side, we were negatively impacted by housing- and mortgage-related stocks owned by our managers, including Countrywide (owned by TCW Select Equities and Bill Miller), Pulte Homes, (owned by Bill Nygren, Bill Miller, and TCW) and Washington Mutual (Nygren’s top holding). More generally, financials and bank stocks were hit hard by contagion fears and this impacted Clipper Fund, which has large exposure to financials although no direct housing-related stocks. It is worth noting that the financial sector is the worst-performing sector in the S&P 500 this year, declining 8.7% through October, while the S&P 500 is up 10.9% overall. In contrast, energy and materials have been the strongest performing sectors, up over 25% on the year. In terms of what the managers who own these stocks are doing with them, by and large they continue to hold them. TCW began reducing its position in Countrywide before the subprime crisis hit, and as of the end of September it was only a 1% position in the fund. At the beginning of the year it was about a 5% position. Pulte remains in their portfolio as well. Washington Mutual remained Oakmark Select’s top holding at the end of the third quarter, at 13% of the portfolio, and Pulte Homes was a 3% position. Based on Miller’s public comments last month it appears that he thinks Countrywide and the homebuilders are very undervalued at current prices, and in fact he added substantially to his Countrywide position during the third quarter. He has maintained (but did not add to) his significant position in homebuilders. What’s your outlook for the U.S. dollar and will it continue to benefit international returns? We think further declines in the dollar are more likely than not, especially versus emerging-market currencies (more on that below). Obviously, any further declines in the dollar will provide a return tailwind for international funds (provided they’re not hedged) as the foreign currencies in which they own stocks translate back into more dollars. But with respect to foreign equities, we have not tactically overweighted our position there for several reasons. One, a weaker dollar isn’t all good for the global economy, since foreign goods become more expensive to U.S. consumers, and profits of foreign exporters may be squeezed. This could hurt earnings of foreign companies, which would impact their stock prices—even while the weaker dollar is making the stocks worth more in dollars. Additionally, we think foreign equity valuations are somewhere in a fair-value range, and not sufficiently compelling in their own right to justify a tactical overweight. Given the strong outperformance of foreign stocks over the U.S. in recent years, many investors may be tempted to increase their weightings to foreign equities, but we don’t believe the data provide a compelling basis for doing so at this time. While we aren’t willing to overweight foreign equities as a way of betting on the dollar, we do believe that further declines are the more likely scenario over the intermediate term. The trade deficit and current-account deficit are two important reasons. The weaker dollar has been helpful in this regard, by making U.S. products cheaper to foreign buyers, and this in turn has helped improve our current account deficit and trade balance. But both remain historically very high as a percentage of GDP, and we think will continue to contribute to pressure on the dollar in coming years. On the other side of the ledger, our trading partners have correspondingly large current-account surpluses, which in recent years they have mostly invested in dollar-denominated assets such as U.S. Treasuries. Their buying of dollar-denominated assets has kept the dollar strong relative to their own currencies, which in turn helps their exports by making them cheaper in dollars, which makes the trade gap worse, and so on. But most experts agree this isn’t sustainable forever. While helping to artificially inflate the value of the dollar relative to their own currencies has been helpful to the Chinese and other Asian economies, eventually it will be an inflationary force in their own countries. At the same time that the dollar has been propped up by foreign investment, governments such as China and those of OPEC nations have shown greater willingness recently to take on more risk in investing their currency reserves in pursuit of higher returns and greater diversification beyond U.S. Treasury bonds—in other words, this important source of demand for dollar-denominated assets has been declining. Meanwhile, the Fed’s recent rate cut has made U.S. bond yields relatively less attractive. These are also factors in favor of continued weakness in the dollar, both in the shorter-term and medium-to-long term. What’s your outlook on interest rates? More important to know than our outlook on interest rates is that our investment strategy is not currently impacted by interest rate expectations, and it rarely is. Unless we are highly confident in our opinion about the direction of rates (and the magnitude of that move) we don’t worry about adjusting our portfolios to take interest-rate expectations into account. Why? There are two reasons. First, the longer-term range of return outcomes, even in fairly extreme interest-rate environments, is pretty narrow. So there’s not a lot of payoff even if you get it right. Correctly forecasting shorter-term moves would add value, but is extraordinarily difficult to do consistently. This is one of the reasons why, in general, we don’t believe in making investment decisions based on macro forecasts: shorter-term noise and sentiment drive movements, and we don’t believe they can be predicted with confidence. Fortunately for us, the way we use bonds doesn’t require knowing what rates will do. We use bonds specifically as a hedge against overall economic weakness that would result in stocks doing very poorly. Please comment on the significant underperformance in Clipper as compared to Selected American this year. As a reminder, both Clipper and Selected American Shares are run by Chris Davis and Ken Feinberg. We owned Selected in our portfolios for many years. When Davis/Feinberg took over managing Clipper last year, we swapped out of Selected into Clipper because we believed (and still believe) that Clipper should outperform Selected by at least a modest amount over the long run. As we often remind our readers, we don’t base investment decisions on short-term predictions or forecasts because they can’t be done accurately with any consistency, and we know sometimes we’ll get the short term “wrong.” But if we can get the long term right more often than not, we can add value, and that is what we seek do. Assessing how we expect each fund to perform over the long term, the key difference between Clipper and Selected American Shares is the number of holdings in each portfolio. Clipper owns about 20 names, while Selected normally has had around 65 to 75 holdings. Therefore, we would expect Clipper to be more volatile than Selected and also likely more out of sync with the broader S&P 500 index. But we believe over the long term, Davis and Feinberg will add additional value by concentrating in their highest-conviction ideas, and that is why we picked Clipper over Selected, although we still really like Selected and expect it to also beat the S&P 500 over time. This year though October, Clipper is only up 3.4% while Selected is up 9.7% (and the S&P 500 is up 10.9%). We have not done a full attribution analysis, but looking at the two portfolios, several things stand out. Major underperformers for Clipper this year have been Harley Davidson, AIG, Merrill Lynch, and JPMorgan Chase. With the exception of Merrill Lynch, all of these names are also in Selected, but their weightings are much higher in Clipper. Harley Davidson is down about 26% this year, and it had a 5.2% weighting in Clipper at the end of June but only a 1.5% position in Selected (Davis and Feinberg still like Harley long-term). AIG was a 10% position in Clipper versus a 4% position in Selected, and AIG is down about 11% this year (they still like AIG also). Merrill Lynch was a 4% Clipper position, but is not held in Selected, as they own other investment banks. Merrill is down about 28% this year. Another point of difference is that Selected has about 15% of its portfolio in foreign stocks compared to about 6% for Clipper. The strong tailwind foreign stocks have had this year (helped by a falling dollar), has helped Selected relative to Clipper. Finally, some small positions in Selected have performed very well this year, such as materials and energy stocks and China-related companies. These names aren’t owned in Clipper as they are lower-conviction holdings. We know that given Clipper’s highly concentrated portfolio, its performance relative to Selected is going to be driven by the relative weightings of its holdings since the investment approach used to pick the stocks for Clipper is identical to what is used for Selected. We expect to see significant differences in short-term performance, including some on the downside, and know that this will be the case going forward. But while Clipper’s recent underperformance may be disappointing, it doesn’t change our long-term view on the fund. Please comment on the changes in Harbor International over the past several years in the context of how the fund is being managed now versus then. Last month we upgraded our opinion on Harbor International from Approved to Recommended and added it to our model portfolios, replacing Artisan International. This fund has been managed by Hakan Castegren since its inception in January 1988. Castegren has one of the best long-term performance records in the business. What has changed over the past several years is that Castegren has built a dedicated team of experienced analyst/portfolio managers that work with him out of Boston. Castegren lives in Bermuda. As we described in our due diligence report on Harbor International published last month, there are four members of the Boston team. They perform most of the on-the-ground company research. The Boston team and Castegren talk daily about stocks and the portfolio. Castegren makes all the final decisions for Harbor International. The Boston team also runs a couple of institutional portfolios, for which they are the final decision-makers, but on which Castegren provides input. (Those portfolios and Harbor International are largely clones of each other.) Formally, the Boston group and Castegren each have a consulting relationship with the other. Prior to the development of the Boston team, Castegren never worked with a dedicated analyst team on Harbor International. Jim LaTorre (now a member of the Boston team) was his sole analyst during the early 1990s. Instead, Castegren relied mainly on his large network of foreign brokers and contacts and his Bloomberg terminal (which he once told us was “the best analyst” he’s ever had). We are very impressed with the Boston team. All of them are experienced and strong analysts that believe in Castegren’s very long-term, low turnover philosophy. Our understanding is that they have been significant contributors of new ideas to the fund that have generated strong performance in recent years. Meanwhile, Castegren is still actively involved in vetting new ideas as well as thinking about big-picture issues and long-term trends that may present great investment opportunities. We really like the combination of Castegren's investment experience, insights, and independent thinking coupled with the Boston team’s bottom-up research and analysis. (We think they are also independent thinkers with good insights.) We think there is a healthy team culture; there is vigorous debate of investment ideas and portfolio decisions. Decisions are consensus-driven, but again, Castegren has the final word on the Harbor portfolio. Ultimately, when Castegren, 73, steps down, we would expect the Boston team to be named by the Harbor fund directors as portfolio manager of the International fund. We expect we would continue to recommend the fund when that happens. — Stapp Financial Planning, PLLC This information is also available at www.stappfinancial.com, or you can download a PDF version. If you do not want to receive future e-mail newsletters from Stapp Financial, link to our subscription form, or send an e-mail to bstapp@stappfinancial.com. Before acting on any advice it is recommended to seek appropriate counsel applicable to your individual circumstances. |
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Stocks overall posted another good month in October, but not all areas of the market were strong. With a lot of representation from financials, which were adversely affected by the subprime lending crisis, the value universe was barely in the black for the month. Growth, meanwhile, saw gains north of 3% in October. Growth has outperformed value by a significant margin so far in 2007. Another broad trend in 2007—that of larger-caps outpacing smaller-caps—didn’t hold in October, however, as smaller-caps beat larger-caps on the month. International equities had a strong month, once again out-returning domestic stocks, and are now up almost 24% on the year. Investment-grade bonds had a solid showing, gaining 0.9% in October, but our tactical positions in commodity futures and short-term emerging market bonds—both of which are funded by a reduction in our bond exposure—did even better, gaining 3.3% and 3.4%, respectively.